SEC Investigating Banks Over Possible Mishandling of ADRs

By Jean Eaglesham

The U.S. Securities and Exchange Commission is looking into whether big banks have been mishandling securities in the arcane but sizable market for American depositary receipts.

The SEC has sent subpoenas to four depositary banks — Bank of New York Mellon Corp., Citigroup Inc., Deutsche Bank AG and J.P. Morgan Chase & Co. — as it examines whether the banks have broken controls designed to prevent market abuse and tax fraud, people close to the investigation said.

SEC investigators are still in the process of interviewing potential witnesses, as well as analyzing a trove of data the banks sent in response to the subpoenas issued late last year, according to people close to the probe. The investigation won’t necessarily result in enforcement action, they said.

Created by financier J.P. Morgan in 1927, ADRs were designed to help investors to avoid many of the complexities and costs of directly owning shares overseas while helping foreign companies widen their investor base in the U.S.

Foreign companies transfer shares to the banks, which use them to back corresponding securities issued to U.S. investors. The securities track the price of the underlying shares.

Trading volumes for ADRs have fallen by 18% over the last five years, according to BNY Mellon, as investors have opted for alternatives such as exchange-traded funds. But big North American investors such as pension funds still held $502 billion in depositary receipts in September 2015, and $3.1 trillion worth of the securities changed hands last year, according to BNY Mellon.

One major focus of the SEC inquiry is the “prerelease” of ADRs, where banks issue depositary receipts without first having the underlying shares in their custody, according to people close to the investigation. The practice was intended to smooth trading by bridging different countries’ settlement times.

Regulators worry the prereleased depositary receipts could be abused for “naked short selling,” an illegal practice where traders bet against a company’s stock by selling shares they don’t own,without borrowing or locating the shares needed to cover the sale, the people said. The agency is also looking at whether such receipts are being used to illegally arbitrage between different tax systems.

Banks say they have controls to prevent such abuses. To get prereleased depositary receipts, brokers have to certify that they are long the shares — not betting against them — and that they will treat the shares for tax purposes as being owned by the bank. Brokers also have to give the bank cash or other collateral for at least the value of the shares.

BNY Mellon, Citigroup and J.P. Morgan are also facing lawsuits filed in federal court by shareholders. The suits allege the banks defrauded retirement plans and other holders of American depositary receipts by using skewed currency rates when converting dividend payments into dollars.

The banks all deny wrongdoing and are fighting the litigation. The currency allegations aren’t a focus of the SEC inquiry, according to people close to the probe.

Write to Jean Eaglesham at jean.eaglesham@wsj.com

Breaking the story

Jean Eaglesham was first to report that the U.S. Securities and Exchange Commission sent subpoenas to Bank of New York Mellon Corp., Citigroup Inc., Deutsche Bank AG and J.P. Morgan Chase & Co. investigating a possible mishandling of securities in the American depositary receipts market, according to sources. The SEC is reviewing troves of data it received, examining whether the banks have broken controls designed to prevent market abuse and tax fraud.

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